3. INTRODUCTION
RATIO
ANALYSIS
3
Ratio analysis is a quantitative method of gaining insight into a
company's liquidity, operational efficiency, solvency and
profitability to evaluate its performance over time and relative to
its peers. Ratio analysis is a cornerstone of fundamental
equity analysis.
Investors and analysts employ ratio analysis to evaluate the
financial health of companies by scrutinizing past and current
financial statements. Comparative data can demonstrate how
a company is performing over time and can be used to estimate
likely future performance. This data can also compare a
company's financial standing with industry averages while
measuring how a company stacks up against others within the
A ratio is the relation between two amounts showing
the number of times one value contains or is
contained within the other
5. TYPES OF RATIO ANALYSIS
RATIO
ANALYSIS
5
Liquidity Ratios
• Liquidity ratios measure a company's ability to pay off its short-term debts as they become due, using
the company's current or quick assets. Liquidity ratios include the current ratio, quick ratio, and working
capital ratio.
Solvency Ratios
• Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets,
equity, and earnings, to evaluate the likelihood of a company staying afloat over the long haul, by paying
off its long-term debt as well as the interest on its debt. Examples of solvency ratios include: debt-equity
ratios, debt-assets ratios, and interest coverage ratios.
Profitability Ratios
• These ratios convey how well a company can generate profits from its operations. Profit margin, return on
assets, return on equity, return on capital employed, and gross margin ratios are all examples of
profitability ratios.
Efficiency Ratios
• Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets and
liabilities to generate sales and maximize profits. Key efficiency ratios include: turnover ratio, inventory
turnover, and days' sales in inventory.
Coverage Ratios
• Coverage ratios measure a company's ability to make the interest payments and other obligations
associated with its debts. Examples include the times interest earned ratio and the debt-service coverage
ratio.
Market Prospect Ratios
• These are the most commonly used ratios in fundamental analysis. They include dividend yield, P/E ratio,
earnings per share (EPS), and dividend payout ratio. Investors use these metrics to predict earnings and
future performance. For example, if the average P/E ratio of all companies in the S&P 500 index is 20, and
the majority of companies have P/Es between 15 and 25, a stock with a P/E ratio of seven would be
considered undervalued. In contrast, one with a P/E ratio of 50 would be considered overvalued. The
former may trend upwards in the future, while the latter may trend downwards until each aligns with its
intrinsic value.
The various kinds of financial ratios available may be broadly grouped into the following six silos, based on the sets of data they provide:
6. RATIO ANALYSIS’ APPLICATIONS
RATIO
ANALYSIS
6
The Importance
May portray a more accurate representation of the state of operations Serve metrics & Static Number on their own company’s performing
Perform the Ratio Analysis
Ratio Analysis over Time Strategic Planning
Ratio Analysis Across Companies compares
with companies with the same expectations
Ratio Analysis Against Benchmark Frequently
implemented by external parties, such as Lenders.
Ratio’s Facts
Most ratio analysis is only used for internal decision making. Though some benchmarks are set externally (discussed below), ratio analysis is often not a
required aspect of budgeting or planning.
Application of Ratio Analysis
The fundamental basis of ratio analysis is to compare multiple figures and derive a calculated value. By itself, that value may hold little to no value. Instead, ratio
analysis must often be applied to a comparable to determine whether or a company's financial health is strong, weak, improving, or deteriorating.
7. THE BOTTOM LINE
RATIO
ANALYSIS
7
There is often an overwhelming amount of data and information useful for a company to make decisions.
A company may compare several numbers together. This process called ratio analysis allows a company to
gain better insights to how it is performing over time, against competition, and against internal goals. Ratio
analysis is usually rooted heavily with financial metrics, though ratio analysis can be performed with non-
financial data.
Comparisons
Competitive Advantage,
companies’ position in the
market.
Trend line predict the
direction of future financial
performance
Operational Efficiency
the degree of efficiency
in the management
8. LIQUIDITY RATIO
RATIO
ANALYSIS
8
The Liquidity ratios measure a company’s ability to meet its short-term debt obligations using its
current assets. When a company is experiencing financial difficulties and is unable to pay its debts,
it can convert its assets into cash and use the money to settle any pending debts with more ease.
Included the quick ratio, the cash ratio, and the current ratio. Liquidity ratios are used by banks,
creditors, and suppliers to determine if a client has the ability to honor their financial obligations as
they come due.
Quick Ratio (Liquid Assets – Inventory) / Short –
term Liabilities
9. SOLVENCY
RATIO
RATIO
ANALYSIS
9
Solvency ratios measure a company’s long-term financial viability. These ratios compare the debt levels of a company
to its assets, equity, or annual earnings. Important solvency ratios include the debt to capital ratio, debt ratio, interest
coverage ratio, and equity multiplier. Solvency ratios are mainly used by governments, banks, employees, and
institutional investor.
10. ASSET UTILIZATION RATIOS
RATIO
ANALYSIS
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DEFINITION AND
CALCULATION
Asset utilization can be calculated for all of a
business's assets at once or for individual
categories of assets such as inventory or
accounts receivable.
1. Return on Assets
2. Account Receivables Turn-Over
3. The Average Collection Period
1. Inventory Turn – Over
2. The Average Age of Inventory
Using Asset Utilization Ratios
1. Analyze your result
2. Compare the result to that of
competing companies
3. Gauge efficiency over time
4. Use asset utilization as part of a
broader analysis
11. DEBT UTILIZATION
RATIO
( U S E F I N A N C I A L L E V E R A G E )
RATIO
ANALYSIS
1 1
Leverage Ratio
Fixed Charge Coverage Ratio
14. MARKET ANALYSIS
• Notes:
• Book Value Per Share = (Com Equity)/(# of Shares)
• Cash flow per share equals net income plus depreciation or amortization divided by the number of shares
outstanding
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RATIO
ANALYSIS
15. RATIO ANALYSIS AND WEALTH
MAXIMIZATION
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RATIO
ANALYSIS
Return
on
Common
Equity X
Book Value
Per
Share =
Earnings
Per
Share
Earnings
Per
Share X
Price
Earnings
Ratio = Price Per Share
Expenses
Sales
Assets
Net
Profit
Margin
Total
Asset
Turnover
Return
on
Assets
Return
on Total
Equity
Debt to
Assets
Ratio
Preferred
Stock
Financing
Return
on
Common
Equity
AND
THEN
16. S O M E A N A L Y T I C A L
P R O B L E M S
I N V O L V I N G A S S E T Q U A L I T Y
It is possible to increase ROI by
avoiding the purchase of new plant
and equipment (Ex. Keep the asset
base low). Of course, the firm may
suffer in the long run.
A high level of accounts receivable
may improve the current ratio, but what
if a large percentage of accounts are
uncollectible?
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RATIO
ANALYSIS
17. S O M E A D D I T I O N A L
A N A L Y T I C A L P R O B L E M S
INFLATION
• Sales and profits may increase
simply because of rising prices, even
without an increase in physical
volume.
• Replacement costs of assets may be
higher than historical costs.
INVENTORY ACCOUNTING
• If firms employ different techniques
(e.g., LIFO, FIFO), comparability of
ratios is impaired.
INDUSTRY AVERAGES
• Some firms operate in more than
one.
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RATIO
ANALYSIS
